Regulatory Capture in the U.S. Petroleum Refining Industry

Regulatory Capture in the U.S. Petroleum Refining Industry Robert Gmeiner Florida State University Abstract The capture theory of regulation concludes that regulatory agencies tend to be captured by the firms they are regulating. This paper tests the capture theory in the recent environment of nuanced agency regulation by the administrative state, focusing on the U.S. oil refining industry. Regulation has tended to narrow refiners’ margins, which harms nonintegrated oil refiners more than vertically integrated. Providing evidence of regulatory capture, complementary analysis of stock returns shows that regulations have benefited the stocks of vertically integrated firms. The narrowing of the margins is primarily due to rising input costs. The capture theory of regulation holds that regulations benefit regulated firms because the regulatory agencies are captured by the firms they regulate (Stigler, 1971). Regulations create winners and losers as products of a political process. The capture theory says that concentrated and well-organized interests will tend to be the winners and reap rents from the regulatory process (Olson, 1971). Owen and Braeutigam (1977) go so far as to write, “No industry offered the opportunity to be regulated should decline it. Few industries have done so.” This view that concentrated special interests are most able to capture regulators is empirically well supported. Kolko (1963) challenges the conventional wisdom that Progressive Era regulations worked to control concentrated economic interests and presents evidence that these regulations further entrenched the positions of the dominant businesses at the time. Gilens and Page (2014) complement this view with an empirical analysis showing that implemented policies have tended to benefit well-connected special interests. Before the 1980s, economic regulation in the United States tended to be specific and involve clear restrictions on prices and quantities. Such regulations were authorized by Congress and implemented by agencies such as the Interstate Commerce Commission and Civil Aeronautics Board. These agencies and their regulations have been scrapped, but have been replaced by an administrative state consisting of agencies that are not new, but have promulgated increasing amounts of regulation since the 1980s. (Meiners and Yandle, 1989; Boskin, 1993). 1 This paradigm of federal regulation by agencies staffed with experts was promoted by Woodrow Wilson (1887). His idea was to ensure that regulation would be more aligned with the public interest and less susceptible to political manipulation. Wilson correctly observed that government tended to support powerful business interests and proposed independent agencies as a solution. However, agencies may suffer from the same problem. In this paper, I test Stigler’s capture hypothesis in the context of the Wilsonian regulatory paradigm. This analysis differs from earlier tests of the capture theory by looking at the cumulative effects of the administrative state after a time of consistent expansion. Agency regulation differs from direct legislative action in several ways. First, agency regulators are unelected and face different incentives than politicians. Second, the regulatory process is undemocratic in that while it has public comments, it does not rely on votes and the final decision is issued by a regulator. Third, the resulting product tends to be nuanced, technical, and hard to dismantle. Specific Congressional regulatory mandates involving agencies such as the ICC and CAB have been repealed, but the administrative state has not been scaled back. The only major effort to reform the administrative state was the National Partnership for Reinventing Government spearheaded by Vice President Al Gore in the early 1990s, but its long-term effects, if any, were scant (Moe, 1994). The Code of Federal Regulations has increased in page count by approximately 80% since 1981 when President Ronald Reagan took office. This recent proliferation of federal regulations merits examining their cumulative effect. Current agency regulations do not impose the same sort of price and quantity controls as were previously used, but there may be overarching cumulative effects that benefit certain interests. In order to examine cumulative effects of federal regulation, I use RegData, a data set produced by Al-Ubaydli and McLaughlin (2015). RegData quantifies industry-specific word counts in the Code of Federal Regulation using machine learning algorithms. It is a time series measure of regulation specific to an industry. Such data can be used to answer broad questions about the cumulative effects of regulation. I use RegData to test whether there are significant cumulative effects of regulation of the U.S. petroleum refining industry on refiners’ margins (output less input costs) and on stock prices of firms in the industry. I focus on the petroleum refining industry for multiple reasons. One is that it is a heavily regulated industry and its concentrated interests are well-known. These include vertically integrated supermajors such as ExxonMobil, Chevron, BP, and Royal Dutch Shell. Another reason is that petroleum refining is very important to the U.S. economy. Beyond these reasons, the petroleum refining industry is ideal for this analysis because there is bidirectional variation in its RegData series, despite an economy-wide upward trend in quantities of regulation. To test the capture theory of regulation, I exploit differences between vertically integrated and nonintegrated firms. Nonintegrated firms buy oil on the market, whereas vertically integrated firms produce their own oil. Because they acquire inputs differently, the two types of firms have different cost structures in their respective profit functions. If increasing totals of regulation result in a 2 narrower margin, nonintegrated firms are comparatively worse off in any case. If the narrowing is due to rising input costs, then vertically integrated firms are better off. This vertically integrated/nonintegrated distinction is valuable only because the largest, most powerful interests in the industry are the vertically integrated supermajors. Whether or not vertical integration is a source of market power is immaterial to this analysis. It is a useful distinction only because the dichotomy of firm type already happens to coincide with differences in size. I find that increasing totals of regulation of the U.S. petroleum refining industry have had the effect of narrowing the refining margin, which intuitively should harm nonintegrated firms. An analysis of the effects of regulation on stock prices shows beneficial effects for vertically integrated firms and harmful effects for nonintegrated firms. I also find evidence that this narrowing of the margin is mostly due to rising input costs. The capture theory of regulation is well supported in this industry in in the current paradigm of federal agency regulation. 1 Relevant Literature The capture theory of regulation originates with Stigler (1971). His central idea is that “regulation is acquired by the industry and is designed and operated primarily for its benefit.” Regulation, as a product of the political process, is subject to lobbying influences. The final product will reflect the desires of those businesses and other interests that have the political clout to get their way. An industry as influential as oil and gas extraction and refining in the United States undoubtedly has political influence. In this regulatory capture tradition, Peltzman (1976) developed and formalized a more general and rigorous model. Both Stigler’s and Peltzman’s models show good intuition, but suffer from oversimplicity. Both models both have only one benefiting group in the regulatory process. While regulations may have tended to favor concentrated economic interests over others, there were always some exceptions. These include the propping up of small refineries during the 1970s oil crises (Kalt, 1981) and the breakup of Standard Oil. Owen and Braeutigam (1977) develop an idea of regulation as insurance for risk averse economic agents that works by slowing the pace of change. Critically for my analysis, Owen and Braeutigam consider unelected regulatory agencies to be endogenous variables that behave more like courts than administrative bodies. As opposed to just modeling regulation, Becker (1983) models competition for political influence. The critical difference between Becker’s model and those of Stigler and Peltzman is that the outcome is not winner-take-all and involves deadweight loss. Multiple industry interests may win some favors as opposed to only one. Porter and van der Linde (1995), Berman and Bui (2001), Managi et al. (2005), Gray (1987) and Gray and Shadbegian (1995), examine the effect of regulation on innovation and efficiency and find positive and negative effects. 3 1.1 Historical Effects of Regulation Early regulation of the petroleum industry centered on the upstream extraction sector as opposed to the downstream refining sector, which I analyze in this paper. Historical effects of regulation are relevant for the insight they provide regarding what could potentially happen as a result of regulation today. While the cumulative effect of increasing agency regulations has not been studied, a few elements of recent industry structure and some newer environmental regulations have been. Market power has a long history as a target of regulation in general and especially in the oil and gas industries. The earliest example of a government regulatory response in the oil refining

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